Money
Opportunity cost vs premium loss: When to surrender your policies
Summary
- Surrendering endowment policies can incur immediate losses, but may reduce overall losses and offer higher returns if future premiums are reinvested wisely.
- Consider other options like converting to a paid-up policy or taking a loan against the policy for short-term liquidity needs.
NEW DELHI : Traditional life insurance plans, often known as endowment policies, are frequently marketed as investment products. However, with growing awareness about the importance of separating insurance and investment, many policyholders are now questioning whether to continue with their existing plans or surrender them.
This decision is not straightforward, as the cash value received upon surrender is usually significantly lower than the premiums paid.
For instance, a client approached 1 Finance, an investment advisory firm registered with the Securities and Exchange Board of India (Sebi). He had an extensive portfolio of 13 endowment policies, with annual premiums totalling nearly ₹3 lakh and a life cover of ₹75 lakh. Having paid ₹43.50 lakh in premiums, he faced a critical decision.
Manju Dhake, vice president-insurance at 1 Finance, recommended surrendering 12 of the policies, estimating a surrender value of ₹33.15 lakh. This would mean an immediate loss of ₹10.35 lakh or 24% of the premiums paid.
However, Dhake emphasized that this strategy would minimize overall losses. “The rationale behind this advice was grounded in the belief that the cumulative yield across all policies was unlikely to surpass 5%," she explained.
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Dhake advised the client to separate insurance and investment needs. She urged him to maintain a single fully paid policy and purchase a term plan worth ₹3 crore to address any gaps in mortality protection. This term plan, costing nearly ₹57,900 annually, would result in net savings of ₹2.41 lakh.
She suggested reinvesting these savings in high-quality instruments like mutual funds and the National Pension System (NPS) for potentially higher returns.
When not to surrender
Deciding whether to surrender an insurance policy is complex and lacks a universal rule. If future premiums can be redirected to high-yield instruments, discontinuing the policy often makes sense.
“If only 3-4 premiums are remaining before the policy matures, we generally advise clients to continue with it," said Nisha Sanghavi, founder of Promore Fintech.
Sanghavi evaluates each client’s income, insurance, and investment portfolio. “We calculate the percentage of premium against a client’s total income. If it is insignificant and other investments are intact, we let the traditional plan continue. In case a client is in bad physical health and may not get additional insurance, then also we let the policy continue," she noted.
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The key is to compare the policy's internal rate of return (IRR) with potential returns from investing the surrender value and remaining premiums in higher-yield products, say mutual funds, NPS or provident fund.
“The second scenario is more rewarding. But do note that you (should) consider the guaranteed surrender value in calculating the policy IRR and not the non-guaranteed surrender value. Non-guaranteed surrender value is generally shown at 4% or 8% in the benefit illustration table, but could be lower when you approach an insurer to take it," Sanghavi cautioned.
If ending the policy altogether is not desirable, converting it into a paid-up policy is an alternative. This means stopping premium payments and receiving a reduced sum assured based on premiums paid to date, either at maturity or upon the policyholder's death.
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“Policyholders who are in a dilemma about surrendering due to the sunk cost fallacy or who do not immediately need the money can convert their policy to a paid-up status. This way, they can use future premiums for other investments without worrying about low surrender value, but considering the time value of money, it is not a great option," said Abhishek Kumar, founder of Sahaj Money.
The sunk cost fallacy refers to the tendency to invest more time or money into a situation that has already incurred losses, even when changing the strategy could minimize or outweigh the losses in the long run.
Other options
Another lesser-known option is assigning the policy to someone else with the insurance company's consent.
ValueEnable, a two-year-old startup, facilitates this by connecting policyholders with individuals or institutions willing to take over the policy. “Policyholders get an amount at least equal to the surrender value while part of the life cover continues. The maturity benefit goes to the buyer, while the death benefit is split between the nominee of the original policyholder and the buyer, as per a pre-defined formula protecting the financial interest of both parties, protecting the financial interest of both parties," explained Satprem Mohanty, co-founder of ValuEnable.
For those needing emergency liquidity but unable to pay premiums, taking a loan against the insurance policy is another option. This secured loan offers a cheaper interest rate than personal loans. “It ensures policyholders can get emergency liquidity in the short term without forfeiting the long-term benefits of life insurance policies, including the life cover," said Mohanty.
Deciding whether to surrender a traditional life insurance plan involves evaluating the potential loss against future investment gains. By considering personal financial circumstances and consulting with financial advisors, policyholders can make informed decisions that align with their long-term financial goals.
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